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The New Subprime Boom: Should We Be Worried?

In a world of government zero interest-rate policy, subprime loans (but not mortgages!) are a tantalizing target for profit-starved banks. However, it is the non-bank entities that are showing the most fearlessness in courting customers with bad credit.

The Subprime King

The Wall St Journal recently crowned private equity manager Wesley Eden “the new Subprime King” for his role in turning hedge fund Fortress Capital into a major player in subprime loans. Eden, who puts his money where his mouth is when it comes to making off-the-beaten path financial decisions, has weathered the bad times after the financial crisis to see personal paper profits exceeding $200 million, while leading Fortress to massive returns from the subprime market.

Eden, who co-founded Fortress, made the call to invest heavily in subprime lending after the company was caught in the financial crisis and its stock fell below $1 a share. Its acquisition of an 80% stake in AIG’s failing consumer loan branch for $124 million (renaming it Springleaf Financial) and mortgage servicer Nationstar has led to impressive gains. Fortress’s stake in Springleaf is now worth $3.5 billion (more than 27 times the purchase price), and Nationstar has provided gains of $350 million over Fortress’s $1 billion investment to date.

This year, Springleaf agreed in principle to buy Citigroup’s OneMain Financial for $4.25 billion, which would make it the largest subprime lender in the United States, with 2.5 million customers and over 2,000 branches. Federal regulators are holding up the deal on anti-trust grounds.

Citigroup, which has been “encouraged” by regulators to downsize and divest itself of risky portions of its business, feels caught in a catch-22 situation by the government’s antipathy to the deal.

Eden feels that the subprime lending market has an undeserved stigma from the 2008 housing crisis. “Subprime is used as an invective, but a lot of people have a problem raising financing. It doesn’t mean they’re bad people. . . it’s not a shameful thing helping people finance themselves. It’s not a bad thing.” He notes that Springleaf does not make mortgage loans, and verifies the employment and income of all applicants (two things that many of the companies that failed during the financial crisis neglected to do).

Not Your Father’s Subprime Market

When most people hear “subprime,” they immediately think “mortgages.” That’s not the case any more. The majority of the subprime lending market today is comprised of auto loans, credit cards, and personal loans. Subprime mortgages make up only 0.3% of first-lien loans now. There were only $2 billion in subprime mortgages written in the first half of 2015, compared $625 billion at the peak of the housing frenzy in 2005. Most banks are not writing subprime mortgages at all, having been burned so severely in 2008. This leaves the market to private lenders, who have learned from the banks’ mistakes.

Banks are now leery of subprime loans of all sorts. Wells Fargo has capped issuance of subprime auto loans to 10% of its auto loan portfolio.

Borrowers are less likely to default on an auto loan than a mortgage payment (because they need their car to get to work), and cars are far easier to repossess than a house is to foreclose on. These facts make subprime auto loans more attractive to lenders. Subprime loan delinquencies are down sharply since the height of the financial crisis.

Just How Big Are We Talking, Here?

The short answer to “How big is the subprime lending industry?” is, “Nobody knows.” There is no easy way to gauge the size of the non-bank entities in the sector, since most of them do not accept deposits. Even the main trade group for subprime lenders, the American Financial Services Association, doesn’t know.

One good way to get a general idea of the size of the subprime loan industry is to ask the credit reporting services. Equifax recently reported that more than one-third of the total of 53.7 million new auto, credit card, and personal loans from January to April 2015 were made to subprime borrowers, the highest percentage since 2007. Of the over 9 million auto loans (totaling almost $183 billion) made during this period, over 2 million of these loans were to people with a credit score under 620.

The total for new (not existing) subprime loans for the first 11 months of 2014 was $189 billion, and the numbers for 2015 will likely be the same, or higher. Equifax reports that the balance on auto loans and leases alone now totals over $1 trillion. If 25% of those are to subprime borrowers, we’re talking about $250 billion in subprime auto loans.

Déjà Vu All Over Again?

While large players such as Springleaf and Satander say they’ve learned the lessons of the subprime mortgage disaster, most of the non-bank subprime lenders are small, privately-owned businesses. This flood of inexperienced lenders (who are far more loosely regulated than banks) is very likely to lower their loan standards for making a deal in this ever-more crowded marketplace. As a result, defaults and repossessions are rising.

A reason for the surge of “mom and pop” subprime auto lenders is the voracious appetite of Wall Street for any kind of return. These subprime auto loans are being bought up, bundled into financial instruments just like the subprime mortgages were (shades of Lehman Brothers!), and resold to investors hungry for yield. It is estimated that nearly $17 billion of these bonds have been sold through July this year.

GM Financial bundled 63,000 car loans last year (not all of them subprime) into $1.2 billion in bonds.

American Credit Acceptance LLC recently made a debt offering comprised of nearly 15,000 auto loans, with nearly 1/3 of them being loans to people with a FICO score under 500 (or no score at all). In March, Santander Consumer sold $700 million worth of subprime loans that had an average FICO score of 552 into the junk bond market, in a matter of hours. According to the New York Times, analysts expect as many as 25% of the borrowers to default, but even then, the return on the bonds should exceed 1%.

A report in July by Nomura revealed that losses on these bundled subprime auto loan bonds grew to 6.6%.

How Much Reward For Their Risk?

While lending to high-risk borrowers carries, well, a high risk, regulators are increasingly concerned over predatory lending rates. This is especially prevalent among the “newbie” lenders, who offer used car dealers a larger cut of the interest rate, in order to win their business. This results in subprime borrowers paying a higher interest rate than they otherwise would have.

American Credit Acceptance LLC is charging between 27% and 28% on over a quarter of loans. Santander was charging up to 20% on the loans it bundled and sold in March.

Springleaf says high interest rates are needed because about 6% of its borrowers default each year.

Regulators, stung by accusations that they are letting the subprime auto lending market get out of control like they did the subprime mortgage industry, are cracking down. Unfortunately for the big lenders, regulators are holding them responsible for possible racial discrimination in loans made on the lot by independent car dealers. This is resulting in an explosion in the size of compliance departments of the lenders.

Don’t Worry, Get Credit?

While the subprime auto and personal loan industry isn’t regulated nearly as tightly as the subprime mortgage industry, most large lenders such as Springleaf are wary of falling into practices that would result in another meltdown. The subprime auto loan market, despite growing by leaps and bounds, is still only a fraction of the industry. $20 billion in financial instruments based on subprime auto loans were sold last year, compared to $600 billion in subprime mortgage-backed securities.

Wesley Eden of Fortress, the “Subprime King,” says that responsible borrowing by subprime customers fuels the economy and helps those who have been most affected by wage stagnation, and leads to improved credit scores. The Guardian newspaper cites a report by Equifax that seems to back this up.

The credit reporting bureau randomly selected borrowers with a FICO score under 550. The ones that took out a subprime auto loan in 2010 saw their credit score rise 52 points — 62% higher than those who did not take out a subprime auto loan.

For the millions of people who lost their homes or jobs in the financial crisis, the subprime lending market can not only help out with surviving, but also help rebuild their financial future. As with all financial decisions, it is up to the consumer to practice due diligence and compare lenders, to make sure they are getting the best terms.